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2 Peter Lynch-Style Stocks That Could Deliver Parabolic Returns

Motley Fool - Mon Oct 23, 2023

Peter Lynch is widely regarded as one of the greatest investors of the modern era. As the manager of Fidelity Investment's Magellan Fund from 1977 to 1990, he averaged an astonishing 29.2% annualized return. To put his fund's performance into perspective, it would take less than 20 years to turn an initial investment of $10,000 into a million-dollar bankroll.

One of Lynch's main tools was his adept use of the PEG ratio, a financial metric that gauges how expensive a stock is relative to its five-year projected growth rate. A PEG ratio of less than 1 is ideal, as it means that a stock is undervalued (assuming the company's growth forecast is indeed accurate).

A hand drawing an exponential curve.

Image Source: Getty Images.

In his iconic 1989 book "One Up on Wall Street", Lynch also advised non-professionals to invest in what they know, to do their own research on a company and not to rely only on analyst opinions, to ignore the noise of the broader markets, and to pay close attention to the financial health of a company. A high debt level, after all, can significantly erode a company's future earnings power.

Putting it all together, Lynch's strategy centers around owning a diversified portfolio of companies with low PEG ratios, strong balance sheets, and unique products and/or services that have yet to catch the eye of Wall Street analysts. The overarching goal of Lynch's approach is to have more winners than losers and to let the winners run while cutting bait on losers when an investing thesis fails to pan out in a timely manner.

That being said, his strategy focuses squarely on a company's fundamental value proposition, meaning that investors shouldn't sell great stocks simply because the market becomes irrational. Instead, an investor's buy or sell decision should come down to how the company – not the market – is performing. In fact, Lynch has often noted in his public commentary that when a great company goes on sale investors should buy more without hesitation. Over a 10 to 20-year period, after all, a company's stock price will ultimately reflect its underlying fundamentals.

Armed with this insight, here is a brief rundown of two emerging growth companies that meet many of Lynch's criteria.

A Warren Buffett-backed Brazilian fintech

StoneCo(NASDAQ: STNE) is a financial services company targeting micro, small, and medium-sized businesses in Brazil. The company's cloud-based payment services address a critical infrastructure problem in the country by allowing smaller, and often underserved businesses, to conduct transactions seamlessly in either the brick-and-mortar or digital realms.

Soon after its 2018 IPO, StoneCo attracted an investment from Warren Buffett's conglomerate Berkshire Hathaway. Although StoneCo's stock qualifies as a small-cap and has been exceptionally volatile since becoming a publicly traded entity, Berkshire still maintains a roughly 3.5% stake in the payment services company.

What's the investing thesis? With a PEG ratio of 0.42, a debt-to-equity ratio of 32.3%, a disruptive product platform, and a total addressable market valued at approximately $24 billion, StoneCo ticks off most of the major boxes as a Lynch-style investment.

The bottom line is that StoneCo stock warrants further due diligence by risk-tolerant investors, given its potential to grow revenue/earnings at an exponential rate over the next decade, combined with its strong balance sheet, and innovative product platform. However, the stock does sport some unique geopolitical and revenue concentration risks that investors ought to bear in mind.

Not just another chip play

ACM Research(NASDAQ: ACMR) is a California-based company that primarily earns money from the sale of single-wafer wet cleaning equipment for the semiconductor industry. ACM is expected to benefit from the worldwide surge in demand for advanced semiconductors capable of handling generative artificial intelligence workloads.

The company's key competitive advantage is its differentiated tech, which provides customers with superior yields and lower chemical consumption relative to competitors. Over the past five years, ACM's revenue has risen at a blistering compound annual growth rate of 60%.

Why might this chip-adjacent stock be an attractive buy? ACM's unique position in the semiconductor industry is forecast to result in double-digit sales growth over the next several years.

While analysts have yet to come to a consensus on its PEG ratio, there's a better-than-average chance that this key metric will ultimately turn out to be well below 1, once everything is said and done. It also sports a rock-solid balance sheet, evinced by its extremely low debt-to-equity ratio of 9.71%.

Now, ACM does come with an elevated level of geopolitical risk because of its dependence on the emerging Chinese semiconductor market. However, the company's supercharged growth profile and solid financial position should appeal to investors on the hunt for stocks with the potential to deliver exponential returns on capital over the long term.

Like StoneCo, though, ACM also comes with a heavy dose of geopolitical risk because of its reliance on the Chinese market for much of its growth, which investors shouldn't brush aside without careful consideration.

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George Budwell has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway and StoneCo. The Motley Fool has a disclosure policy.

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